CFDs

The Do's and Don'ts of CFDs

Trading CFDs can multiply your profits, save you tax and help protect your investment portfolio - but you should start by bearing in mind a few basics.

1.) "Do ask your broker how your account will be classified, as this will indicate the type of service you can expect."

If you are a private client then you are owed 'best execution' - in other words there must be no increased spread to hide a hidden commission. Private client status may also give you access to higher levels of arbitration and compensation. As a private customer, the broking firm is obliged to segregate your funds from any company money. Even experienced traders can request that they are treated as private customers.

Most CFD brokers will want to classify your account as 'intermediate', which indicates a high degree of knowledge and experience on your part. As an intermediate customer, you are not legally owed best execution. In practice, this means that a company can give a customer a different price to the prevailing market, representing an additional cost.

2.) "Don't be baffled by commission-free dealing."

There is no such thing as a free lunch, so be sure you know the true cost of dealing. For example, the market spread for Vodafone is 0.25p. If you're paying any more than this, your price is probably being altered to cover your broker's profit. Find out what commission you are to be charged and ensure that you do not pay increased spread and commission on top. Check the interest rate to be charged to your account.

3.) "Do make sure you don't overgear your account."

Ultimately, if you can't afford to take up an equal physical position, then you probably are overgeared.

4.) "Do try to use CFDs in conjunction with your overall portfolio, not as a substitute."

CFDs are an instrument of a share price. If you are looking to hedge an entire portfolio of stock, then a CFD may not be the most appropriate instrument. FTSE futures or options may well be easier and cheaper.

Apart from speculation on the price of stock morvements, you can use CFDs to hedge a long-term hold. Suppose, for example, that a stock rose dramatically after a set of results and you wanted to lock in that profit without selling the underlying stock. You could sell short the CFD so that, if the price does weaken, you will make up with your CFD what you would lose on the underlying share.

5.) "Do look at the tax management advantages for hedged positions over using short spread-bets."

In practical terms, let's say you owned 100,000 shares in Vodafone and wanted to hedge your position. The price goes up and you feel that it is going to fall in the short term. You sell a CFD against your underlying stock and the share continues to rise. This creates a capital loss on the CFD which can be offset against the capital gain on the stock. This kind of offsetting is not possible with losses made from a spread bet.

6.) "Don't take losses greater than your profit expectation."

Be rational and never believe the market owes you a favour. The major reason that CFD traders lose money is two-fold: they overgear and tend to run losses for too long while taking profits too quickly.

7.) "Do always give your trade a time limit within which you expect to see profit, since interest on the value of the whole deal accrues daily."

8.) "Do remember that shares may move dramatically and can, at times, be suspended from trading."

Do remember that shares may move dramatically and can, at times, be suspended from trading. Stocks outside the FTSE 100 may be extremely volatile and inappropriate for less experienced clients. Never forget that it is possible to lose more money that your initial deposit.

9.) "When comparing CFDs with spread bets, remember to include all costs."

CFDS can often work out cheaper. Here's an example of a quote obtained from a major betting company compared with a similar trade through a CFDs dealing firm. Suppose you want exposure to Royal Bank of Scotland (RBOS) to the turn of 1,000 shares or £10 a point.

SPREAD BET

RBOS spread bet price is 1,554.25 to 1,567 a spread 12.75 x £10 a point, or £127.50.

CFD

RBOS real market spread is 1 point or £10 - but you would need to add commission of around £30 to buy (plus £30 to sell) .

The savings may seem relatively small until you multiply them by the number of trades made each year. The savings are even greater if you look at FTSE futures over similar spread-bets. The real spread for a FTSE futures contract is half a point of £5, whereas some spread betting companies charge 10 points, or £100.